Small Consolation

By

Neil A. Martin

Updated March 1, 1999 12:01 a.m. ET

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S hare prices rose in Tokyo last week, aided by a strengthening dollar that boosted prospects for Japan's exporters. The benchmark Nikkei 225 finished Friday at 14,376, up 1.9% on the week and a respectable 3.7% on the year. But while the comeback may be heartening, given the lackluster performance of the Japanese market during the past year, most of the major blue-chip stocks like
Sony
,
Canon
,
Kyocera
,
Omron
and
Fuji Film
are still trading well below their 12-month highs, and the market remains far from its 1998 high of 17,264.

More important, the surge in large-capitalization stock prices has all but obscured a remarkable rally in small stocks. Tokyo's little publicized over-the-counter market, which hit rock-bottom in October, has seen the share prices of many small and medium-sized companies rocket by 50%-200% in the past few months. The Nikkei OTC index closed Friday at 902, up 24.4% on the year and 47.6% since October. In the same span, the Nikkei advanced by 11.5%.

A number of new issues, including recently-listed
Oracle Japan
, a subsidiary of the U.S. computer software supplier, and
JAC
, a marketing outfit selling used cars, have helped pump new life into the $72 billion market. Another positive has been the recent collapse of Japanese government bond prices, which sent investors scurrying for investment alternatives.

While the Japanese have only recently started riding the boom, foreigners have been leading the way, delighted that they can at least find something -- anything -- to buy in Japan. They pumped a record $485.2 million into the market last year, far eclipsing domestic institutions and individual investors. And in January, their net purchases came to $75 million.

"Many global fund managers, who had abandoned the small-cap sector as part of a general selloff of Japanese stocks, have been lured back into the market by the rally," says Curtis Freeze, who runs the
Prospect Japan
fund, a $75 million closed-end listed in London.

"Others who held larger Japanese stocks have moved down to smaller issues because of other worries about Japan's deteriorating economic performance and the impact of a strong yen on exporters," he adds. "Whatever their reasons, they have made a huge difference."

Martin Roy Porter, president of Jardine Fleming Investment Trust & Advisory Co. in Tokyo, agrees. "The rally has been quite remarkable," he says. "Even though Japan continues to struggle with its economic and financial problems, we have found that if you focus on companies that are well-managed and strategically placed in specific sectors of the economy, you can do well and make money."

Only a few weeks ago, Jardine Fleming launched a $40 million investment trust, the Japanese equivalent of a mutual fund, dedicated to companies traded on the OTC, the second section of the Tokyo stock exchange and regional bourses. Named, oddly, after Oda Nobunaga, the ruthless military dictator who unified Japan in the 16th century, the Nobunaga fund is aimed at tapping the growing interest of Japan's domestic investors and is doing very well. "We are currently up 4.5% from where we started at the end of January," Porter observes, "and continue to see encouraging inflows from retail investors."

Ditto for the U.S and European-managed funds dedicated to small-caps. For example, three U.S. mutual funds have directly benefited from the ongoing small-cap boom. The largest of the group -- the $140.9 million
Fidelity Japan Small Companies
fund -- gained 31% in value last year and is ahead 15.75% this year, while the $54 million
Warburg Pincus Japan Small Company
fund rose 12.76% in '98 and is up 17.52% year-to-date.

DFA Japanese Small Companies, a $117 million index fund, ended 1998 up 18.33% but was hit by the strong yen toward the end of last year and is currently down 4.22%.

On the closed-end side,
Japan OTC Equity
, a Nomura-run fund with assets of more than $57 million, and
Japan Equity
, a $68 million, small-cap-biased fund advised by Daiwa Securities, have attracted enough demand from investors to be selling at premiums of 17% and 24%, respectively, to their underlying net asset values, according to Morningstar. And two London-listed closed-ends -- the $130 million
Atlantis Japan Growth
fund and the aforementioned Prospect Japan fund -- are up 32.1% and 2.3% since January.

"People are just now beginning to become aware that Japanese small-caps are running away from the market," says Prospect Japan's manager Curtis Freeze. "Investors realize that smaller companies can take market share away from the big boys and not only survive but prosper."

Atlantis Japan's manager, Edwin C. Merner, agrees: "People looked at the small-cap funds last year and saw that they were among the best-performing funds and had positive returns, which is sort of a rare commodity these days."

Whatever is behind the boom, the price performance of some small-caps has been eye-popping. During January alone, the share prices of
Seta
, a computer-game software manufacturer, skyrocketed 209.3%.

On February 5, the Japanese subsidiary of Oracle Corp. sold five million shares for more than $500 million, becoming overnight the single biggest OTC issue and representing about 10.4% of that market's total capitalization. "Given the company's prospects for strong growth in the information technology field, Oracle's presence will considerably strengthen the high-tech image of the OTC market." predicts Ken Segawa, a leading small-caps specialist with Warburg Dillon Read in Tokyo.

OTC stocks are trading, on average, at less than 15 times projected earnings, compared with an average of 60 times for the stocks in the benchmark Nikkei 225.

"Liquidity problems scared people away from small-caps in the past," says Prospect Japan's Freeze, "but now if you are looking for companies with double-digit sales and earnings growth trading at eight to 10 times future earnings, you won't find them in the main market."

In 1996, a number of large foreign institutions suffered heavy losses after being lured into over-the-counter stocks that proved to be dogs and were too illiquid to easily unload.

The experience embittered many fund managers, who until recently had avoided the market. One dramatic example that pummeled the market last year occurred in October, when trading in shares of
Tescon
were suspended after the maker of printed circuit board testers couldn't persuade its main bank to renew loans. Tescon, which had been highly touted to foreigners by Japanese brokers at small-company seminars in Tokyo for two years, fell victim to an overly ambitious expansion, undercut by a lack of capital. The company's interest-bearing debt doubled to $76.5 million, roughly equal to Tescon's annual sales.

Tescon's shares, which are being delisted, are currently priced around 33 cents, compared with $10 at the start of 1998 and a June 1997 high of $22.34.

With such recent and unpleasant history in mind, some Japan watchers worry whether the small-cap boom will last, given that the market has had only two significant rallies in the past 10 years.

The OTC market tends to be highly seasonal, rising in the first half of the year and declining in the second, driven by downward revisions of corporate earnings projections. During the past 10 years, the OTC market has fallen eight times and risen only twice.

So: Can the market break past patterns and maintain its upward momentum?

Some analysts, such as Warburg Dillon Read's Segawa, fear the rally may falter if the economy continues to deteriorate. Regardless of how good their niche market is, small companies are vulnerable to supply-demand factors, credit problems and general market trends that affect the overall environment in which they operate. Hence, if Japan's recession deepens, they say, small companies will find it harder to maintain past high growth patterns.

"There is a lot of hype in the market," gripes Atlantis Japan's Ed Merner. "There is a lot of talk about low P/E ratios, which really isn't relevant because some companies have no growth and aren't going to grow anyway," he contends.

Others argue that, slowdown or not, many of the companies listed -- not only on the OTC market, but also on regional exchanges and the Tokyo exchange's second section -- will remain resilient and be worth keeping in any growth-oriented portfolio.

"Whatever quick gains you might enjoy in a rally like this one," says Atlantis Japan's Ed Merner, "the proper perspective is still two to three years." The key, he and some others argue, is to find companies that have their corporate feet firmly planted in sectors of the economy that are doing nicely in the current hard times and hence should grow strongly when good times return.

Merner points to software companies such as Data Communications System. Staffed by former employees of Nippon Telegraph & Telephone, it excels in financial and communications-related technology and in developing new technologies in multimedia and electronic trading.

He also likes discount and specialty retailers that target specific markets.

Among them: Mishimatsuya, a chain specializing in selling children's, maternity and baby clothing from roadside outlets;
Jeans Mate
, which focuses on the youth market and peddles mostly jeans and T-shirts;
Sazaby
, a wholesaler, retailer and designer of handbags and personal accessories;
Thanks Japan
, a department-store chain;
Don Quijote
, which sells personal products, electronics appliances, food and goods for the sports and leisure markets through outlets that have aspects of both convenience and discount stores.

In electronics, his favorites include
Mimasu Semiconductor
, a highly profitable, low-cost wafer processor that continues to enjoy high profit growth despite an overall downturn in the semiconductor business. He also likes Sumisho Auto Lease, which is profiting strongly from Japan's growing market for corporate vehicle leasing.

And while the Japanese are eating out less now than they did in better times, when they do go out they look for value at cheaper prices. That has enhanced the prospects for chains such as
Joyfull
, a Kyushu-based family-restaurant group whose stock is favored by Prospect Japan's Freeze.

Joyfull recently reported a 37% increase in net profits on a 34% gain in revenues for the year through December. It's forecasting 26% growth in net profits this year on a 22% increase in revenues. The shares recently were trading around eight times this year's earnings.

Freeze also likes
Fast Retailing
, a fast-growing casual-clothing retailer similar to America's Old Navy chain. Fast Retailing, he says, is "taking market share away from the larger retail stores by focusing on what people want."

Large-scale retail chain store operator
Yamada Denki
, whose share price has jumped more than 160% in the past year still has room for growth, Curtis believes because its bargain-basement prices continue to attract careful shoppers.

"While overall consumption is not strong," Freeze observes, "people are buying computers and peripherals in order to hone their skills for the job market and for self-training. The number of computers per household is still far less than half what it is in the U.S.

Warburg's Segawa has four companies on his buy list:
Aucnet
, Japan's first used-car auctioneer utilizing communications satellites;
Paltac
, the country's largest wholesaler of cosmetics and detergents, with a large foreign staff and run by a foreigner, with sales and earnings growing annually at double-digits;
Resort Trust
, top-ranked operator of members-only resort hotels, and
Miroku Jyoho Service
, a fast-growing, highly profitable developer of financial software for accounting firms.

In sum, there is no shortage of promising stocks in an OTC sector providing a spark in a broader market that has lost more than 60% of its value over the past nine years. And many of these small stocks could stay hot for quite a while.

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